Wage fund theory

Smith said that the demand for labour could not increase except in proportion to the
increase of the funds destined for the payment of wages. Ricardo maintained that an
increase in capital would result in an increase in the demand for labour. Statements
such as these foreshadowed the wages-fund theory, which held that a predetermined
“fund” of wealth existed for the payment of wages. Smith defined this theoretical fund
as the surplus or disposable income that could be used by the wealthy to employ others.
Ricardo thought of it in terms of the capital—such as food, clothing, tools, raw
materials, or machinery—needed for conditions of employment. The size of the fund
could fluctuate over periods of time, but at any given moment the amount was fixed,
and the average wage could be determined simply by dividing the value of this fund by
the number of workers

Assumptions

1.According to this theory, wage fund is rose before the employment of workers

2.The workers are paid equally out of the wage fund

3.The units of labor are homogeneous

4.The wage level is flexible to the change in number of workers employed

5.Money is just a medium of exchange

This theory was generally accepted for 50 years by

economists such as Nassau William Senior and John Stuart Mill. After 1865 the wages-
fund theory was discredited by W.T. Thornton, F.D. Longe, and Francis A. Walker, all
of whom argued that the demand for labour was not determined by a fund but by the
consumer demand for products. Furthermore, the proponents of the wages-fund
doctrine had been unable to prove the existence of any kind of fund that maintained a
predetermined relationship with capital, and they also failed to identify what portion of
the labour force’s contribution to a product was actually paid out in wages. Indeed, the
total amount paid in wages depended upon a number of factors, including the
bargaining power of labourers. Despite these telling criticisms, however, the wages-
fund theory remained influential until the end of the 19th century.

According to Mill, wage level is determined by wage fund and the number of worker’s
employed. To pay the laborer, a wage fund is raised. Once the wage fund id rose, it is
kept constant. The wage fund is distributed among the worker’s employed. The
workers are assumed to be paid equal amount. It is because the units of labor are
homogeneous. If more workers are employed each worker gets fewer amounts and if
less number of workers is employed each worker gets more amount of money. The
wage level is given by the ratio of wage fund and number of worker’s
employed.Mathematically,

This theory can be explained with the help of table and figure as following:

Wage fund (W.F) No. of workers (N) Wage level (W.F/N)

Rs 1,00,00,000 50000 Rs 200

Rs 1,00,00,000 100000 Rs 100

Rs 1,00,00,000 150000 Rs 66.67

In the above table, wage fund raised is Rs 1, 00, 00,000. When the number of workers
employed is increased from 50000 to 100000 and 150000 the wage level is decreased
from Rs 200 to Rs 100 and Rs 66.67 respectively. It is due to constant wage fund
distributed among more workers. If we represent wage level with respect to number of
workers employed we obtain a convex curve.

In the above figure, the downwardly sloped convex curve represents inverse
relationship between wage level and no of workers employed.

Regardless of the makeup of the fund, the obvious conclusion was that when the fund
was large in relation to the number of workers, wages would be high. When it was
relatively small, wages would be low. If population increased too rapidly in relation to
food and other necessities (as outlined by Malthus), wages would be driven to the
subsistence level. Therefore, went the speculation, labourers would be at an advantage
if they contributed to the accumulation of capital to enlarge the fund; if they made
exorbitant demands on employers or formed labour organizations that diminished
capital, they would be reducing the size of the fund, thereby forcing wages down. It
followed that legislation designed to raise wages would not be successful, for, with
only a fixed fund to draw upon, higher wages for some workers could be won only at
the expense of other workers.

Criticisms

1.Wage fund is not raised before employing the workers but is rather raised on the
basis of worker’s employed

2.Wage paid to workers differs from place to place, time to time, person to person and
organization to organization.

3.Units of labor are not homogeneous. They differ in skill, knowledge, strength,
education, attitude etc.

4.Wage level is not flexible. Wage level fall is opposed by workers and trade unions

5.Money is not mere medium of exchange. It has effect on production, investment,

employment level etc.

Marginal Productivity Theory of Wage:

The marginal productivity theory of wage states that the price of labour, i.e., wage rate,
is determined according to the marginal product of labour. This was stated by the
neo-classical economists, especially J. B. Clark, in the late 1890s.

The term marginal product of labour is interpreted here in three ways: marginal
physical product of labour (symbolized by MPPL), value of the marginal product of
labour (symbolized by VMPL) and marginal revenue product of labour (symbolized by
MRPL).

When marginal product of labour is expressed in money terms we obtain VMPL.

MRPL is the change in total revenue following a change in the employment of labour.
Marginal productivity theory of wage states that wage of labour equals VMPL (=
MRPL). Employer will employ labour up to the point until market wage equals
labour’s value of the marginal product (VMP) and marginal revenue product (MRP).

Assumptions of Marginal Productivity Theory of Wage:

i. Perfect competition prevails in products market and in labour market. Perfect
competition in product market implies that products are homogene-ous and the price of
the goods is given for all firms in the market. Perfect competition in labour market also
implies that labour as well as firms behave as ‘wage-takers’; no one can influence the
wage rate.

Consequently, labour supply curve, SL, becomes perfectly elastic. Since wage rate does
not change, labour supply curve incidentally, becomes the average cost curve of labour
(ACL) and it coincides with the marginal cost curve of labour (MCL).

ii. Law of variable proportions operates.

iii. The firm aims at profit-maximization.

iv. All labourers are homogeneous and are divisible.

v. Labour is mobile and is substitutable to capital and other inputs.

vi. Resources are fully employed.

Wage rate will be determined by the interaction of

demand and supply curves of labour in the market. Labour demand curve is explained
by the VMPL curve. Since perfect competition exists in the product market, VMPL
curve coincides with the MRPL curve. VMPL = MRPL curve is the firm’s demand
curve for labour.

This curve slopes downward because of diminishing marginal returns. In Fig. 6.11,

VMPL = MRPL = DL represents the firm’s demand curve for labour.

Further, as perfect competition exists in the labour market, the labour supply, SL =
ACL = MCL, curve has been drawn perfectly elastic.

In Fig. 6.11, E is the equilibrium point since at this point labour demand equals labour
supply. The equilibrium wage rate thus determined is OW. Corresponding to this wage
rate, equilibrium level of employment is OL.Note that for OL amount of labour, VMPL
= MRPL is LE, which equals wage rate OW. At this going wage rate (i.e., OW) the
employer will be maximizing profit by employing OL units of labour. However, less
(more) labour will be employed if market wage rate rises above (falls below) OW.

Limitations of Marginal Productivity Theory of Wage:

This neo-classical theory of wage determination is subject to a large number of

criticisms. Most of the criticisms of this theory are directed against the assumptions.
Most of the assumptions are unrealistic.

The Main Criticisms are:

i. In the real world, perfect competition does not exist—both in the product market and
in the labour market. Im-perfect competition is found in all the markets. This theory,
therefore, has limited applicability in the real world. If it is applied to the imperfectly
com-petitive market, the workers will be subject to exploitation.

ii. Labour can never be homogeneous— some may be skilled and some may be
unskilled. Wage rate of a worker is greatly influenced by the quality of labour. A
higher wage rate is enjoyed by the skilled labour compared to the unskilled labour. This
simple logic has been totally ignored by the authors of this theory.

iii. Perfect mobility of labour is another unrealistic assumption. Mobility of labour may
be restricted due to socio--political reasons.

iv. The marginal productivity theory of wage ignores the supply side of labour and
concentrates only on the demand for labour. It is said that labour is demanded because
labour is produc-tive. But why labour is supplied cannot be answered in terms of this
theory.

This is because of the fact that, at a given wage rate, any amount of labour is supplied.
But we know that higher the wage rate, higher is the supply of labour. This positive
wage-labour supply relationship has been ignored by the makers of this theory.

v. Full employment of resources is another unrealistic assumption.

vi. This theory, in fact, is not a wage theory but a theory of employment. Wage rate is
predetermined. At the given wage rate OW, how many units of labour are supplied can
be known from this theory. In this sense, it is a theory of employment and not a theory
of wages.
vii. Finally, this theory ignores the usefulness of trade union in wage determination.
Trade union, through its collective bargaining power, also influences wage rate in
favour of the members of the organization